The Bond Market is Flashing a Recession Warning
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Investors have choices to make when investing in bonds. One of those choices is the maturity date of their bonds and or bond portfolio. We can buy short-term bonds, long-term bonds, and or everything in between. Not all that different than buying a bank CD. We can buy a short-term six-month CD, we can buy a longer-term five-year CD, or we can create a diversified portfolio of CDs to arrive at our target maturity date.

Short-term bonds, just like short-term CDs, typically pay a lower interest rate than long-term. And that's because all else being equal, short-term bonds are less risky than long-term bonds. Interest rates fluctuate daily, and it's hard to know if buying a long-term bond today will appear to be just as attractive to us in the future when the interest rate environment might look dramatically different.

As a reminder, when you buy a bond, you are loaning your money to someone else, either a corporation, a municipality, or the government. In return, they're paying you interest on your loan, just like you would pay interest on money that you borrow from someone else. So if you want to commit to taking more risk and loaning your money to them for a longer period of time, those entities will typically compensate you for that risk and pay you a higher interest rate.

But right now, that's not what's happening. Right now, the yield on a AAA rated three month U.S. Treasury bond is about 5%. On the other hand, the yield on a 10 year U.S. Treasury bond is about three and a half percent. In other words, you are getting paid a lower interest rate for taking more risk, the exact opposite of what you would expect to happen.

When this happens, it's called a yield curve inversion. Everything we know to be true about investing in bonds gets flipped on its head or inverted. The safe short-term bonds are paying a higher interest rate than riskier long-term bonds.

Right now, we're experiencing the most inverted yield curve in history. We've never seen short-term three-month treasury bonds yielding this much more than long-term 10-year treasury bonds. So why is this? What does this mean? How should retirement investors be thinking about their bonds and the broader economy going forward?

Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and that's exactly what we will be digging into today. For the links and resources mentioned in today's episode, just head over to youstaywealthy.com forward slash 186. ♪♪♪

So why is this happening right now? Why are riskier longer-term bonds yielding less than safer short-term bonds? Well, in short, two things are happening simultaneously. First, as we all know, the Fed has been raising short-term interest rates lately to combat inflation, and this has driven up rates on those short-term bonds. In addition, for the first time in years, cash in a high-yield savings account is actually earning meaningful interest.

But while we're all celebrating the extra interest that we're getting from our savings accounts, there are other much more sophisticated investors who are worried that economic trouble might be around the corner.

Instead of taking advantage of the higher interest rates on cash and short-term bonds, they are instead buying up long-term 10-year treasury bonds. They're predicting that the economy is going to be headed into a rough patch. And as a result, long-term bond yields will be lower in the future.

In other words, they believe that locking in a 10-year bond paying 3.5% today will look pretty attractive in the not-so-distant future, and they want to load up before their prediction comes true. This race to buy longer-term dated bonds, in turn, has pushed the yields lower, lower than short-term bonds.

According to Campbell Harvey's research, which I'll link to in the show notes, since 1969, an inverted yield curve that stays inverted for a full calendar year quarter has been followed by a recession every time. And that's what we've experienced here recently. The yield curve inverted toward the end of last year, toward the end of 2022, and it has stayed inverted through the first quarter of the year. Now, like most things in life, nothing is certain.

Campbell's thoughtful research is based on what happened in the past and doesn't guarantee that it will play out exactly the same way in the future. In fact, Campbell Harvey, the person who discovered the yield curve inversion indicator, believes right now that his model might have a false signal and may not be as reliable in today's environment.

He states three reasons for the potential lack of reliability. Number one, he notes that unemployment currently remains low. Specifically, according to his comments on April 4th, which I'll link to in the show notes, he shares that there are 1.7 job openings for every unemployed person. In addition, the tech sector is responsible for most of the current layoffs.

This is a sector that had skyrocketing hiring rates over the last three years. So their current layoffs, in his opinion, are just kind of walking back some of the excess hiring that they did in recent years. Number two, the second reason he shares for why the yield curve indicator may not be reliable right now is that Americans' balance sheets are much healthier today than they were leading up to the last prolonged recession, which we experienced in 08-09.

Even if housing prices continue to suffer here in the short term, record low mortgage rates that consumers have locked in coupled with their healthier balance sheets, in his opinion, likely won't cause the same type of catastrophic situation that led to a recession last time.

Number three, the final reason is that everyone knows about the yield curve indicator. It's hard to miss someone talking about the yield curve inverting and being a predictor of future recessions. Since everyone is keeping an eye on this indicator, his theory is that businesses are watching and being more cautious as a result. Instead of getting caught off guard, they're being proactive and making changes in advance, knowing that the bond market might be signaling that troubles ahead.

All that being said, Campbell believes that a recession could still occur if the Fed isn't careful and continues to be overly aggressive with rate hikes. So once again, all eyes continue to be on the Fed and what their next move might be. If they happen to navigate all this properly, it is possible that they find a way to combat inflation while also avoiding a recession.

Now, predicting whether we go into a recession or not is not the purpose of today's episode. The purpose is to try and make sense of these headlines, the same headlines that we see show up every few years, so we can improve the chances of staying the course and staying committed to our long-term plans.

Knowledge is power. I think it's important to understand how the bond market works, what a yield curve is, what it might be telling us, why we're getting paid less to take more risk and why we shouldn't make dramatic changes to our plan based on predictions about the future.

It's a breath of fresh air to me when you have an academic like Campbell Harvey or Bill Bangan who coined the 4% rule acknowledge that history isn't always perfectly indicative of the future, that our plans and our decisions can be fluid, that perhaps the yield curve indicator is less reliable today, or that retirees could actually withdraw more than 4% using more current updated assumptions.

But the current state of the market still requires retirement investors to make some important decisions or at least feel comfortable with the decisions that they've made and the plan that they currently have in place. Should retirement savers buy short-term bonds and capitalize on higher interest rates? Should they buy long-term bonds to better protect their nest egg against a recession or an upcoming catastrophic event?

If the safest bonds in the world are currently yielding 3% to 5%, what does that mean for expected returns from stocks and other asset classes? We last covered the inverted yield curve here on the show in September of 2022. And in that episode, I attempted to answer some of these questions.

Given that we're still talking about the yield curve today and more and more investors are waking up to the strange reality that we're living in with regards to bonds, I wanted to replay a short segment from that episode. Just note that while the yields I quote in that episode are slightly different than where things stand today, the same comments and principles still apply.

Now, even though an inverted yield curve doesn't necessarily guarantee that a recession is around the corner, economic officials do often pay close attention to bonds and interest rates, and they can be influenced to take action when the curve inverts in an effort to try and avoid a catastrophic event.

As noted in recent episodes here, the Fed has put themselves in a pretty tough position at the moment, and time will tell if the policy response to the current economic conditions will prevent a recession or at least mitigate its severity.

Until then, investors like you and me, we still have decisions to make with our money. And with the one-year U.S. Treasury yielding more than the 10-year, many investors might be wondering what the catch is. Why would anyone buy a 10-year bond? Shouldn't they just put their entire bond allocation in one-year treasuries since they're yielding more?

To help arrive at an answer to these very good and logical questions, we have to recognize that although U.S. Treasury bonds don't contain investment or credit risk, they aren't 100% risk-free. For example, if I buy a 10-year U.S. Treasury bond yielding 3.5%, I know the exact outcome of my investment every year for the next 10 years, and I can build a plan around that.

That certainty can be valuable for a certain investor with a certain set of goals.

On the other hand, if I buy a one-year US treasury bond to capture the slightly higher yield of 4%, well, it's anyone's guess what my options are going to be when I go to reinvest my proceeds in 12 months. What if a one-year treasury in 12 months is only yielding 2% at that time? Well, that previous 3.5% yield on a 10-year bond is now looking pretty attractive to me. In fact,

If that were to happen, I may now be tempted to buy a longer-term bond next time around with my proceeds. Let's say I buy a five-year bond with my proceeds because I don't want to get stuck again in 12 months. But shortly after buying, interest rates spike, and now my five-year bond isn't looking like such a great choice. You can see how this one short-term decision can spiral into a series of emotional, challenging, and sometimes costly decisions in the future.

My guiding philosophy in life and in investing is to focus on the things we can control. We can't control where interest rates will be in the future, and it's impossible for us to know if buying a one-year bond today is better than buying a 10-year bond, which is why I prefer to own and hold thousands of bonds with different maturities over long periods of time, helping to reduce interest rate risk and maybe more importantly, reduce the odds of me getting in the way and becoming my

own worst enemy trying to outsmart the markets.

Over a long period of time is a key word there because in retirement, creating an income stream from our investments for the next 30 to 40 years is a long period of time. And trying to time the bond market and obsess over how to take advantage of an inverted yield curve and determine what maturity bond to buy next, these things rarely match up with the goal of creating a consistent, reliable retirement paycheck for the next 30 plus years while also ensuring we don't run out of money.

There are, in my opinion, far more important decisions to be making than how can I take advantage of an inverted yield curve over the next six to 12 months, especially when you can invest in thousands of high-grade bonds through an ETF or a mutual fund at virtually no cost.

Yes, it's not fun to see the principal value of your bond fund decline here in the short term. But again, we aren't investing for the short term, or at least we shouldn't be. Most retirement savers and retirees aren't investing for the next 12 months or even 10 years. A 65-year-old entering retirement today is investing for the next 30 years. And just like stocks, we can't let short-term events cause us to react and make emotional changes that can have negative long-term impacts.

Okay, two final things I want to touch on before we part ways today. First, I want to point out what the current state of the bond market and specifically the risk-free rate means for your overall investment plan going forward.

The risk-free rate, the 4% that you can earn on a one-year treasury bond right now today should be your current starting point for any investment that you're considering. In other words, if you're going to take any risk with your investments, you're going to expect something more than 4%. This means that riskier asset classes like stocks

should have a higher future expected rate of return today than they did yesterday or a few months ago. Otherwise, nobody would invest in them. Nobody would invest in riskier asset classes if they didn't expect a return that properly compensates them for the risk they're taking above and beyond US treasuries. So keep this in mind as you evaluate your asset allocation and financial plan and look to make any necessary investment changes going forward.

Just take note of how quickly interest rates can move. The one-year treasury is yielding about 4% today, and that might be your starting point today, but that can change tomorrow or next month. So don't latch onto this 4% number that we've discussed today. Second,

While the uptick in short-term interest rates may not change your long-term asset allocation decisions, it may present an opportunity to improve your cash management strategy. To put this opportunity into perspective, the one-year U.S. Treasury was yielding about 0.4%. Yes, that same one-year U.S. Treasury was yielding about 0.4% at the end of 2021, so eight months ago. At the same time, that annual headline inflation rate was around 7%.

Today, that risk-free rate, that one-year US treasury bond is in that 3% to 4% range. Today, it's 4%. And annualized headline inflation sits around 8%. So if your cash is managed appropriately, you're able to better protect your purchasing power today, given higher interest rates than eight months ago.

Unfortunately, it takes some extra effort to do so because the big banks that we all know by name, they are not passing these higher interest rates off to their customer. So you'll either need to leverage an online bank like Ally or Capital One or consider buying individual U.S. treasuries as a cash alternative.

Just remember that unlike an FDIC money market account provided by an online bank, U.S. treasuries do fluctuate in value day to day. So if you buy a one-year U.S. treasury as a money market alternative today, you'll want to commit to holding it until maturity. You'll want to commit to holding it for that entire 12 months.

We'll end there for today. As always, if you have any questions or comments, please shoot me an email at podcast at youstaywealthy.com. And to grab the links and resources from today's episode, just head over to youstaywealthy.com forward slash 186. Thank you as always for listening, and I'll see you back here next week. This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.